Brexit Briefings 7: The Dramatic Fall in the Pound Brings Both Costs and Benefits OCTOBER 20, 2016

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Brexit Briefings 7: The Dramatic Fall in the Pound Brings Both Costs and Benefits 1) It appears that the recent decline in the value of the British pound is beginning to translate into product price

1 Brexit Briefings 7: The Dramatic Fall in the Pound Brings Both Costs and Benefits 1) It appears that the recent decline in the value of the British pound is beginning to translate into product price inflation and higher costs for some UK manufacturers and retailers. 2) The recent dispute over product price increases between Tesco and Unilever, foreshadows future disputes between vendors and producers over who will bear the brunt of inflationary product pressures. 3) It is likely that the pound will remain weaker, as the consequences of the June referendum are still unclear. Depreciation will likely increase costs not only for food retailers, but also for nonfood retailers as well. 4) There are benefits to retailers and brand owners of the sterling s fall. However, the benefits are principally for retailers that are not mass-market, store-based retailers. Luxury brands, Internet-only retailers and local producers stand to gain from depreciation. DEBORAH WEINSWIG Managing Director, Fung Global Retail & Technology deborahweinswig@fung1937.com US: HK: CN:

This report is part of a Brexit Briefings series of regular reports which analyze the impact of the decision of the British electorate to leave the European Union (EU) on the UK s economy, consumers

2 This report is part of a Brexit Briefings series of regular reports which analyze the impact of the decision of the British electorate to leave the European Union (EU) on the UK s economy, consumers and retailers. This is the seventh report in our Brexit Briefings series, in which we continue to analyze the impact of the Brexit vote on the domestic economy, consumer confidence and retail sales in the UK. The focus of our reports in this series so far has been short term, in other words before the UK actually leaves the EU. This report investigates the impact of the sharp decline in sterling following the Brexit vote and ensuing economic consequences such as higher price inflation and retailer and manufacturer cost increases. We also look at which types of retailers and producers stand to gain from a lower pound. It appears that the depreciation of the sterling is beginning to trickle down to product price inflation and higher costs for UK manufacturers and retailers. The dispute over product price increases between Tesco and Unilever, foreshadows future disputes between vendors and producers over who will bear the brunt of inflationary product pressures. The weakness of the pound will likely increase costs not just for food retailers but also for non-food retailers as well. It is very likely that the pound will remain at weak as the consequences of the June referendum are still unclear. Companies that stand to benefit include luxury-goods firms, to which international shoppers are flocking; online-only retailers such as ASOS and boohoo.com, because they generate much of their revenues abroad; and local food and apparel producers. 2

Tesco, Unilever and Marmitegate It appears that the dramatic plunge in the value of the British pound is starting to translate into product price inflation and higher costs for UK manufacturers and

3 Tesco, Unilever and Marmitegate It appears that the dramatic plunge in the value of the British pound is starting to translate into product price inflation and higher costs for UK manufacturers and retailers. Last week, the UK s largest grocery retailer, Tesco, and the country s largest food and personal care brand owner, Unilever, were engaged in a dispute over which party should bear the brunt of product price increases, apparently due to the weakness of the pound. Unilever stated that it was increasing prices in the UK market, and proposed a price increase of 10% to offset higher costs of imported production materials. Unilever also reported 3Q16 trading results last week, and stated that unfavorable currency movements had negatively affected revenues in the quarter. Unilever stated that the company s costs of selling in the UK have gone up significantly following the drop in the value of the pound, and the company s profit margins would decline unless prices are raised. In response to Unilever s demands, Tesco pulled certain Unilever products, such as Ben and Jerry s ice cream and Marmite spread, off its online platform. Unilever also manufactures other well-known products such as Dove soap, Flora spreads, Hellmann s mayonnaise and Lynx. The dispute between Tesco and Unilever was eventually resolved within 24 hours, and Unilever products were put back on sale at Tesco. Neither party commented on how the issue was resolved. However, the standoff between the two companies sparked much business media concern, and some commentators even dubbed the incident Marmitegate, as the dispute foreshadows the potential for future commercial disputes between vendors and producers due to inflationary pressures on input costs. Plunging Pound The pound has fallen by nearly 20% against the US dollar since the June Brexit vote referendum, and almost 6% in October alone. 3

4 The British pound has fallen by nearly 20% against the US dollar since the June Brexit vote referendum, and by almost 6% in October alone. The pound is currently trading at its lowest level against the US dollar in 31 years, and the result is that UK importing companies are now seeing their input and product costs rising by about one-fifth. Furthermore, commodities and food imports are mostly priced in dollars, as are apparel and footwear products sourced from China. Where Will the Pound Go From Here? It is unlikely that the pound will strengthen unless the Bank of England steps in and raises the benchmark interest rate. The central bank lowered interest rates in August, and may cut rates further as a stimulatory measure if the UK economy slows. Bank of England executives have stated that the bank will maintain accommodative monetary policy over inflation targeting. Some banks such as HSBC estimate that the pound could weaken even further next year, to as low as US$1.10, down from the current level of US$ Furthermore, given that the UK government has not stated its plan for negotiations with the EU, including over access to the single market, and that negotiations will likely be protracted, it appears very likely that current market uncertainty will prevail and hence sterling will remain at current depressed levels. Some banks such as HSBC estimate that the pound could weaken even further next year, to as low as US$1.10, down from the current level of US$ Meanwhile, the US dollar has reached its highest level against a basket of its major currency peers since March this year, and will likely strengthen further, reflecting expectations of Hillary Clinton winning the US presidential election in November and the Federal Reserve raising interest rates in December this year. 4

5 The UK imports approximately 40% of total food consumed, and that percentage is increasing. Impact on Food and Non-Food Prices The weakening pound lowers purchasing power and leads to inflationary pressures. The Bank of England is expecting UK inflation to rise slightly above the bank s 2% target, possibly reaching 2.4% in Many financial analysts and economists anticipate an increase in food price inflation in the short term, due to the collapse of the pound. The counterbalance to these forecasts is that economists forecasts, both in the wake of the Brexit vote and in previous periods, have been shown to be very wide of the mark. Aside from the pound s depreciation, the sharp shock to the economy that many economists forecast should the UK vote to leave the EU has not materialized: shoppers have continued spending and companies have continued hiring. Economists faults notwithstanding, it is likely that food prices in the UK will rise, as the UK imports approximately 40% of total food consumed, a percentage that is increasing. Thus far, the impact of rising food and product prices has been offset by many retailers having hedged unfavorable currency exposure in anticipation of a possible collapse of the pound following the Brexit vote. However, the benefits of currency hedging contracts will decrease coming into 2H17, according to S&P. Consumer prices inflation data, just released from the Office for National Statistics and covering September, show overall inflation climbing from 0.6% in August to 1.0% in September. Clothing prices moved from (1.2)% in August to +1.0% in September, but food remained solidly deflationary, at (2.3)% in September versus (2.2)% in the previous month. 5

Impact on Retailers Tesco and other UK supermarket retailers are reluctant to raise product prices, as they are already embroiled in an ongoing price war with discounters Aldi and Lidl and struggling

6 Impact on Retailers Tesco and other UK supermarket retailers are reluctant to raise product prices, as they are already embroiled in an ongoing price war with discounters Aldi and Lidl and struggling to maintain market share. Tesco s CEO warned suppliers that they could not expect consumers to absorb price increases. Furthermore, UK grocers do not have much wiggle room to raise product prices. The average operating margin of UK food retailers has decreased to 2.5% in the past few years from about 4%. Tesco recently announced ambitions to increase its FY16 operating profit margin from 1.9% to % by fiscal 2020, so a product price increase would not be a step in that direction. Tesco argued that some products such as Marmite were made in the UK, and the company had negotiating leverage due to its size and scale. However, smaller companies will not have the same clout to stand up to larger suppliers. It is likely that in the coming months, there will be many more similar disputes between retailers and their suppliers. Going forward, many weaker UK retailers will continue to face profit squeezes and associated challenges. Should the pound remain at the current low level, cost pressures of UK nonfood retailers will also be compounded, as retailers are already grappling with higher labor costs, due to the introduction of higher minimum-wage legislation and other costs such as pensions enrollment as well as e-commerce investments. Retailers will be faced with the difficult conundrum of raising prices for customers or taking a hit to profit margins. This is a challenge that retailers are more used to facing in emerging markets that have volatile currencies and suffer from drastic devaluation patterns, such as in Brazil and Russia. Furthermore, Kantar Worldpanel, reported that apparel, footwear and accessories sales have declined for four consecutive months up to September 25, in the biggest downturn in UK fashion since The British Retail Consortium expects non-food store prices to rise in 1H17. 6

The British Retail Consortium expects non-food store prices to rise in the first half of 2017, as there is a limit to how much retailers can absorb costs without raising prices.

7 The British Retail Consortium expects non-food store prices to rise in the first half of 2017, as there is a limit to how much retailers can absorb costs without raising prices. Marks & Spencer, New Look and Matalan are among the retailers that will be strongly negatively impacted by pound weakness, as they purchase approximately 70% of their inventory in US dollars, according to Moody s. Marks & Spencer, New Look and Matalan are among the retailers that will be strongly negatively impacted by pound weakness, as they purchase approximately 70% of their inventory in US dollars, according to Moody s. Benefits of a Lower Pound There are undoubtedly some benefits to retailers and brand owners of the pound s fall. However, the benefits are principally for retailers that are not mass-market, store-based retailers. Luxury brands and retailers: It boosts tourist shoppers. As we write this, Burberry has reported a 30% jump in its UK sales, due to the depreciation of the pound attracting international shoppers. Internet-only retailers: For retailers with substantial international operations, depreciation flatters their reported revenues. Internet-only retailers, in particular, stand to benefit. ASOS generates around 57% from international markets, while boohoo.com makes around one-third of its revenues overseas. Smaller-scale, domestic producers: A weak pound is a boon to domestic, UK-based food producers and textile manufacturers; however, these will often be relatively small players. 7

What Food Manufacturers and Retailers Have Said to Date Food manufacturer Nestle stated in August that the pound s devaluation is increasing cocoa and coffee import prices.

8 What Food Manufacturers and Retailers Have Said to Date Food manufacturer Nestle stated in August that the pound s devaluation is increasing cocoa and coffee import prices. Global cosmetics company L Oreal stated that it will be careful in increasing product prices in the UK, as it is not the consumer s fault that some production costs are rising. Sports Direct International has stated that profits will be lower due to the weaker pound, as imported products are purchased in US dollars from Chinese suppliers. UK specialty apparel chain Next warned that the company may have to hike prices next year by up to 5%. Swiss cheesemaker Emmi indicated that prices will need to rise in the UK. Risk from Brexit Trade Legislation It is very likely that the pound will remain weak, as the consequences of the June referendum are still unclear. The British Retail Consortium stated that it was paramount to strike a favorable exit deal with the US in order to avoid raising store prices due to higher tariffs under World Trade Organization rules. The UK retail sector is the country s largest importer, and the sector already pays billions in customs duties. Former deputy prime minister Nick Clegg has stated that the UK would face average food import customs tariffs from the EU of 22% if the UK were to leave the EU single market without a new trade agreement. In the case of failure to reach a new trade agreement or transitory agreement outside of the current single market, UK exports to the EU would be subject to World Trade Organization rules, which include average tariffs of 2% on non-agricultural products and 22% on agricultural products. 8

KEY TAKEAWAYS It appears that the dramatic plunge of the pound is starting to translate into product price inflation and higher costs for UK manufacturers and retailers.

9 KEY TAKEAWAYS It appears that the dramatic plunge of the pound is starting to translate into product price inflation and higher costs for UK manufacturers and retailers. The dispute over product price increases between Tesco and Unilever foreshadows future disputes between vendors and producers over who will bear the brunt of inflationary product pressures. The weakness of the pound will likely increase costs, not just for food retailers, but also for non-food retailers as well. It is very likely that the pound will remain weak, as the consequences of the June referendum are still unclear. There are benefits to retailers and brand owners of the sterling s fall. However, the benefits are principally for retailers that are not mass-market, store-based retailers. Luxury brands, Internet-only retailers and smaller-scale, local producers stand to gain from depreciation. 9

10 Deborah Weinswig, CPA Managing Director Fung Global Retail & Technology New York: Hong Kong: China: Eva Kubicka Senior Research Associate HONG KONG: 8 th Floor, LiFung Tower 888 Cheung Sha Wan Road, Kowloon Hong Kong Tel: LONDON: Marylebone Road London, NW1 6JQ United Kingdom Tel: 44 (0) NEW YORK: 1359 Broadway, 9 th Floor New York, NY Tel: FungGlobalRetailTech.com 10

BREXIT: FIRST-TAKE ON THE IMPACT FOR RETAIL

BREXIT: FIRST-TAKE ON THE IMPACT FOR RETAIL Sterling and European stock markets were rocked by the vote for the UK to leave the European Union. On the eve of the result, traders had expected the UK electorate